Choppy times ahead for government bond market in 2010

The UK government bond market will have to navigate around two distinct obstacles in 2010, neither of which will make for particularly plain sailing.

The first of these is the likely end of the Bank of England's Quantitative Easing (QE) policy.

The Bank's foray into these uncharted policy waters has been designed to increase the overall quantity of money in the economy. The US monetary authorities have implemented the same policy response as a result of the financial crisis.

The Bank of England is likely to end its Quantitative Easing programme soon

In QE, the Bank purchases significant quantities of UK government bonds, or gilts, with the expectation the sellers will re-invest the money elsewhere, thereby prompting a more general rise in asset prices and stimulating economic activity.

At its November meeting, the Bank opted to raise the stock of funds set aside for such purchases by a further £25bn to £200bn - equivalent to around 14pc of annual gross domestic product.

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For the gilts market, these purchases have created significant activity, with the government effectively acting on both sides of the market, as both a seller of new gilts and a buyer of existing stock.

To put this into perspective, the current £200bn QE limit is only a little shy of the £225bn worth of gilts the government intends to issue by the end of this fiscal year.

We suspect the end of this unconventional policy course is now clearly in sight, with the Bank looking unlikely to extend QE once the current limit is reached at the end of January.

In a matter of weeks, therefore, the gilts market will bear sole responsibility for meeting the government's borrowing needs.

As with any product or service, a marked increase in available supply stands to put downward pressure on prices until such time as there is sufficient demand to clear the market.

This is likely to be the case in the UK government bond market, with lower prices necessary to ensure there are sufficient domestic and overseas buyers of gilts.

The flip side of a drop in bond prices, however, is a higher rate of interest - or yield. This is because a bond's price is inversely related to the rate of interest paid on the bond over its life.

This is of potential concern, as higher interest rates put yet further pressure on government finances, via higher debt servicing costs, which, in turn, increases the need to cut back spending elsewhere and/or raise taxes.

Meanwhile, with all other debt instruments being priced off the cost of government borrowing, including corporate bonds and fixed rate mortgages, higher gilt yields will prompt a generalised rise in borrowing costs. That also threatens to limit growth.

In the UK, the extent of this anticipated rise in yields depends partly upon the credibility of the government's 'road map' to fiscal sustainability.

The bond market is likely to demand tougher concessions on government borrowing should it be concerned the current high volume of bond supply will prove more than a temporary feature.

This makes the General Election, expected by May next year, the second of our two key obstacles regarding next year's outlook for gilts.

As we head into 2010, we expect the bond market to pay increasingly close attention to the opinion polls. What will be hoped for is that the next government enjoys a strong majority.

This would boost the chances that the large budgetary overhang will be addressed in a timely and decisive manner.

A hung parliament, by contrast, would have the opposite effect, with any indications of this in the polls adding extra upward pressure on bond yields (and downward pressure on prices) - not least as such an outcome would be deemed to raise the odds that the UK's triple-A sovereign rating will come under threat.

It is clear the gilts market will have to navigate some choppy and unpredictable waters as it sails into 2010.